Will Bartleet, CIO and Portfolio Manager of Pacific Multi-Asset
Unlocking value in Japanese companies
Assets that offer asymmetry, where the upside potential is greater than the downside risks are the holy grail of investing. Sometimes these are found in unlikely places; one such opportunity lies within the Japanese stock market. In these uncertain times, let’s start with the downside protection. This comes in the simplest form possible: lots of cash on company balance sheets. Japanese companies have been hoarding cash for 30 years after the traumatic experience of the bubble bursting in the early 1990’s. In a world of high corporate debt, more than half of Japanese companies have net cash on their balance sheet.
Another legacy is cross shareholdings, where companies bought the shares of other companies. As these have often been kept for decades, investors ignored them when they valued Japanese companies. And as they had so much of both cash and other securities, it looked as though their profitability was low. But what would happen if they sold their cross shareholdings and used the proceeds and their cash to buy back shares? Then suddenly their earnings per share would soar and their value would be apparent to all the world.
AVI Japan Opportunity Trust seeks to exploit this opportunity. Its investment trust structure allows it to invest in the cheapest parts of the market, sometimes in smaller companies where the most extreme value can be found. So just how cheap are these companies? Cash makes up 50% of the market capitalisation and if you add the cross shareholdings then it’s over 75%. So perhaps they are just terrible businesses? Let’s take an example of Fujitec, the manufacturer and repairer of lifts and escalators. Their global peers are hugely profitable: Kone and Schindler have ROE’s of over 30%. If you’ve ever seen the impact of a lift that’s out of service on a hotel or business, you’ll know why they can charge such high rates. Fujitec’s ROE appears to be 9% but this is because it has 50% of its market cap in cash. The ROE excluding cash and non-core assets is 17% making it a good business and an attractive buy-out target.
What is changing to release this value? Corporate governance in Japan is going through a quiet revolution: this started in 2014 when the proxy advisory giant Institutional Shareholder Services announced that it would be recommending that investors vote against the re-election of top executives in companies that had failed to hit a five-year average ROE hurdle of 5%; last year the Financial Services Agency mandated that institutional investors disclose how they voted at all AGMs; so far this year, there has been a 50% increase in shareholder proposals compared to 2014. Sometimes, however, companies need a nudge and here AVI have long experience in activism. Japanese boards close ranks when confronted with aggressive activism, but a behind the scenes approach can be much more effective.
Finally, why aren’t more investors taking advantage of this? Firstly, as noted, some of the most outrageous value opportunities lie in small and micro-cap stocks. Here, the market cap is equal to net cash, or to put it another way, you buy the shares and get the business for free. Most investors can’t take on that illiquidity whilst a permanent capital vehicle is perfectly suited for this. Lastly, most investors won’t have heard of these companies: more than half of them aren’t covered by a broker, compared to just 2% of US companies. A great example of where active management can really add value.
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